Working Paper: NBER ID: w14894
Authors: Riccardo Dicecio; Edward Nelson
Abstract: Developments in open-economy modeling, and the accumulation of experience with the monetary policy regimes prevailing in the United Kingdom and the euro area, have increased our ability to evaluate the effects that joining monetary union would have on the U.K. economy. This paper considers the debate on the United Kingdom's monetary policy options using a structural open-economy model. We use the Erceg, Gust, and López-Salido (EGL) (2007) model to explore both the existing U.K. regime (CPI inflation targeting combined with a floating exchange rate), and adoption of the euro, as monetary policy options for the United Kingdom. Experiments with a baseline estimated version of the model suggest that there is improved stability for the U.K. economy with monetary union. Once large differences in the degree of nominal rigidity across economies are considered, the balance tilts toward the existing U.K. monetary policy regime. The improvement in U.K. economic stability under monetary union also diminishes if imports from the euro area are modeled as primarily intermediates instead of finished goods; or if we assume that the pressures reflected in foreign exchange market shocks, instead of vanishing with monetary union, are now manifested as an additional source of disturbances to domestic aggregate spending.
Keywords: Euro Membership; UK Monetary Policy; Structural Model; CPI Inflation Targeting; Economic Stability
JEL Codes: E32; E42; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Joining the euro area (F36) | Improved stability for the UK economy (E63) |
| Large differences in nominal rigidity across economies (E19) | Diminished improvement in stability from euro area membership (F36) |
| Imports from euro area modeled as intermediates (F16) | Diminished improvement in stability from euro area membership (F36) |
| Foreign exchange market shocks (F31) | Disturbances to domestic aggregate spending (E20) |
| UK's existing monetary policy regime targeting CPI inflation (E52) | More effective stabilization of the economy than adopting the euro (F36) |
| Significant nominal rigidities exist (E39) | More effective stabilization of the economy under existing regime (E63) |
| UIP shocks do not disappear (J65) | Increased variability of UK inflation under monetary union (E31) |
| Imports treated as intermediates (F10) | Diminished overall economic stability under monetary union (F36) |